System and method of implementing massive early terminations of long term
financial contracts

ABSTRACT

A method of and system for terminating or assigning outstanding OTC derivative transactions between a plurality of financial institutions (banks). The system comprises: a processing station arranged to receive transaction data describing a plurality of transactions from a plurality of banks via the Internet. The processing station comprises: a linking module for linking different versions of the same transaction received from different parties to that transaction; an analysis module for determining a set of linked transactions between a plurality of different banks, wherein each bank has debts and claims towards other banks in the set; a calculation module arranged to calculate an aggregated value of each set of linked transactions and select the set of linked transactions which has an aggregated value within bank-specified tolerance limits acceptable for executing a termination; and an execution module for executing a termination or assignment of the selected set of linked transactions.

CROSS-REFERENCE TO RELATED APPLICATIONS

This application is a divisional of U.S. application Ser. No. 12/584,973filed Sep. 15 2009, which is a continuation of U.S. application Ser. No.10/154,689 filed May 24, 2002, which is a continuation in part ofInternational Application No. PCT/NL00/00856, filed on Nov. 23, 2000 andpublished in English under International Publication No. WO 01/39060 onMay 31, 2001, the entire disclosures of which are incorporated herein byreference. This application claims the priority of Netherlands PatentApplication No. 1013662 filed Nov. 24, 1999, the entire disclosure ofwhich also is incorporated herein by reference.

FIELD OF THE INVENTION

The present invention concerns a system and method of implementingmassive early terminations of long-term financial contracts, such as OTC(Over the Counter) derivative contracts. More particularly, the presentinvention relates to a system for a network based, automated process todecrease the number of outstanding financial derivative transactionsbetween counterparties with the aim of lowering the gross and net creditexposures between counterparties and/or to enhance risk-control and/orlower operational costs and/or risks for each counterparty.

BACKGROUND OF THE INVENTION

Financial derivatives are contracts of which the price/value of thecontract varies with the value of an underlying instrument. Theunderlying instrument may be a bond, an equity, an interest rate, acurrency exchange rate, commodity price or, in a recent development,even a credit risk.

Financial derivatives can either be standardised contracts traded on arecognised Exchange or OTC traded (see below). In the first case, one ofthe counterparties in a trade is an Exchange. As the contracts arestandardised there is no difference between the net and grossoutstanding volume for each market participant. Buying on day 1 andselling on day 2 leads to a total disengagement of the position. Futuresand exchange-traded options are common instruments in this class.

As the prices of these instruments are objectively known at any point intime they can fulfill the function of “benchmark instruments” for thecalibration of other prices. This “benchmark” function can as well befulfilled by some liquid underlying instruments, like government bonds,stocks of companies with a sufficient high market capitalisation orfrequently traded currency-pairs.

The other possibility is that the contracts are individually negotiatedand tailor-made between two counterparties (so called “over the counter(OTC) transactions”). In this case entering into a contract on day 1 andentering into a similar contract with the opposite sign on day 2 maylead to a market risk position of close to zero, but still to 2contracts which have to be maintained until their designated finalmaturity. Instruments in this class are swaps, swaptions, FRAs, caps,floors, FX-forwards, all kind of options on stocks, bonds, interestrates or currencies, as well as more exotic varieties and creditderivatives. Since the OTC contracts are individually negotiated, noobjective market price exists. The parties need to do their ownvaluation of the contracts both when dealing as well as later on whenestablishing the market value of their contracts during their life. Thisvaluation is normally based on pricing formulas using so-calledvaluation parameters for input. There are different models that can beused, depending on the preferences of a party. The valuation parametersare either estimated or derived from benchmark instruments using othertheoretical models. This subjective method of establishing the value ofa contract means that the parties do get to different results. Thedifferences are small in simple products but can be quite substantial inmore complex products.

Active players in these instruments may run books that comprised of tensof thousands of individual transactions (the largest dealers even havemore than 200,000 outstanding contracts). The management of thesepositions is no longer possible on the level of the individualtransactions, but only on an aggregated level. A common way of riskmanagement is to sort the OTC-instruments by underlying instrument, andthen express the market value and some risk-characteristics intime-buckets.

Frequently used risk-characteristics or sensitivities to the valuationparameters are for example the so-called Greeks: delta, gamma, vega andtheta. Delta refers to the first differential from the value of thetrade for a change in value of the underlying instrument, thus enablingthe judging of the risk-content of the position expressed in units ofthe underlying instrument. Gamma refers to the second differential fromthe value of the trade for a change in value of the underlyinginstrument, or the change in delta for each subsequent change in thevalue of the underlying instrument. Gamma can be extremely non-linear,even for individual trades, and certainly for portfolios of many trades.Vega is the change in value of the instrument for a small change in thevolatility of the instrument. Theta is the change in value of theinstrument from one day to the next, all other parameters held constant.In case the contracts have a foreign currency component, the net presentvalue of the foreign currency amount is sensitive to changes in theFX-rates. Hence, these net present values should also be considered arisk-characteristic. For derivatives where the main underlying is theinterest rate for various time periods, (the so-called yield curve), thedeltas are normally calculated referring to changes in interest rates indifferent time segments (or time buckets) of the yield curve.

Where the present application later on refers to the Greeks, allsensitivities to the valuation parameters should be included. The Greeksfrom individual trades can be aggregated for a portfolio of trades toform the corresponding Greeks of the portfolio. A set of trades isdefined as being risk-neutral when the aggregated Greeks are close tozero. Hence, the aggregated value of a risk-neutral set of trades isquite insensitive to changes in the valuation parameters

The institutions active in the OTC markets use computer systems forstoring the details of the transactions they have done. These systemsnormally have the capability to revalue all transactions and calculatethe Greeks of all transactions on a unilateral basis. A normal procedureis also to do a daily mark-to-market, which means re-valuation of alltransactions according to the prevailing market conditions. Themark-to-market values as of close of business are stored in databasesfor calculating profit and loss, risk exposure, credit exposure etc. TheGreeks or the risk parameters can be calculated in different ways usingdifferent units or different scaling factors. Semantically, the riskparameters contain the same information although the numerical valuesmay differ, depending on the methodology used by the risk-managementsystem.

The professionally dealing participants in the OTC markets are banks,investment banks and other financial institutions (later referred to asdealers or market-makers). ISDA, the International Swap and DerivativesAssociation, has roughly 180 primary members and is a trade organisationfor all organisations in some way active in the OTC derivatives market.A substantial number of these dealers consider themselves to be“market-makers” in a more or less broad spectrum of products. This meansthat they are always willing to put a price on a potential transactionthat is brought to their attention by a customer or another dealer, beit direct or through a broker. In roughly 80% of the transactions bothparticipants are dealers/market-makers. Only 20% of the transactionshave an “end-user” as party to the agreement. The role of the marketmaker is to provide liquidity to the market. The motivation for themarket maker is to deal OTC derivatives in high volumes, both “buying”and “selling”, making revenues out of the bid/offer spread.

The total outstanding volume of interest rate based OTC derivatives haspassed the 60 TRILLION US$, the OTC market as a whole has a size of over88 TRILLION US$ according to statistics as of December 1999 collected bythe Bank for International Settlements.

The motivation for entering into an OTC derivative transaction is themanagement of market risk positions, either for the purpose of hedging(immunising a position from changes in market prices) or for the purposeof deliberate position taking (trying to make a profit from an expectedchange in market prices).

The advantage of derivatives is that the market risk of substantialamounts can change hands without the need to really transfer theunderlying (nominal) values.

OTC derivative contracts can have maturities up to 30 or even 50 yearsbut the majority of contracts traded are in the up to 10 years maturityrange. The long maturity means that financial institutions (banks)active in this market build up large sets of live transactions. Holdingthese live transactions is associated with operational cost andoperational risk.

The economic value of an individual contract can be several milliondollars. An individual contract can also have a significant market riskmeaning that the value can change several hundred thousand dollarsduring the course of a normal business day. Banks need to manage theaggregated market risk so that they don't accidentally run into tradinglosses.

Since banks are both buying and selling these types of contracts, theaggregated value and market risk of all transactions done by a bank aretypically just a fraction of the gross value and market risk of thetransactions. (With gross value it is meant the sum of the absolutevalues of the individual contracts). Still, in each bilateralrelationship a bank will have either a net claim or a net debt. A claimis a credit exposure and as such is subject to capital sufficiencyrequirements imposed by the regulators. Hence, OTC derivatives tradingalso generates credit risk and capital costs.

PROBLEMS RELATED TO THE STATE OF THE ART

As explained above, the purpose of entering into an OTC transaction isthe transfer of market risk, either to increase or decrease the totalexposure to certain market parameters, depending on the preferences ofthe counterparties. As an unavoidable consequence however, the partiesare getting a new exposure to two different risk categories, credit riskand operational risk.

As the market moves, the net present value of an transaction will moveaway from the roughly zero level at which the transaction was concluded.This means, one party gets a claim on the other party, the validity ofthe transfer of market risk is therefor always dependent on the abilityof the parties to fulfill their obligations under the contract. It is oflittle use to have had the correct market view and get a claim of X on acounterparty that has gone bankrupt in the meantime. Therefore, animportant factor in the development of the OTC markets has been themanagement of credit risk.

Originally, dealers calculated this credit risk as a percentage on eachtransaction (depending on the type of transaction and the maturity) andcharged the so-calculated amounts against the credit risk limit theirinstitutions were willing to expose themselves to each counterparty.Bank supervisors force banks to hold capital against both market risk aswell as credit risk. Therefore each transaction or a certain sub-set oftransactions, for example all transactions with counterparty X, will beinternally charged with the cost of capital tied up in the transaction.

The total capital of the bank is a limited and scarce resource thateffectively puts a limit on the volume of banking activities. It istherefore desirable for a bank to try to reduce the capital tied up bythe unintentionally acquired credit risk in OTC derivatives.

As the market grew rapidly, it was soon discovered that the sum of alltransactions between two counterparties was much less dependent onmarket changes than the sum of the individual transactions. Many activemarket participants are dealing back and forth with each other in bothdirections, sometimes even on a daily basis. This reduces thesensitivity of the portfolio: “all transactions with counterparty X” forchanges in market values. For this reason more sophisticatedinstitutions are now calculating the credit exposure based on the sum ofall transactions with each counterparty.

This development has been made possible by the fact that ISDA developedthe so-called “Master Agreement”, whereby all individual trades aredeemed to be one Agreement, and many countries around the world changedtheir bankruptcy laws to accommodate this development (the so called“netting” process). The European Banking Federation has recently as welldeveloped a Master-Agreement. The bilateral netting will, for the banksthat are using this method, reduce the credit exposure. Still, manybanks are not using netting, thus calculating exposures on a grossbasis, or with a combination, i.e. they use netting in combination witha limited “add-on” for each individual trade.

The credit exposure can for obvious reasons never be netted betweencounterparties. A claim on party X can not be offset by a debt to partyY. The asymmetric nature of credit exposure means that the totalexposure of a bank normally grows with the number of counterparties itis dealing with. The problem is aggravated if the exposures arecalculated on a gross basis, since then the exposure even grows with thenumber of transactions.

In another attempt to prevent the exposure from growing outside theavailable limits of a bank, especially in the longer time buckets, whichare the most risky and therefor the most scarce, counterparties agree onso-called “break-clauses”. This allows one or both parties to terminatethe transaction at specified points in time at the prevailing marketprice.

A party may also choose to assign his part of a deal to a new party. Insuch an assignment, a deal between two parties A and B, where A assignshis part of the deal to a third party C, C will step in as the newcounterparty towards B. By an assignment, both A, B and C can getreduced or increased exposure towards the other parties. The assignmentrequires the consent of both party B and C.

Even then a substantial number of potential trades could not be done,because counterparties were no longer willing to accept each other.Hence, the concept of “credit-mitigation” has been invented. In thisprocess, when the net present value of all transactions exceeds acertain, bilateral set limit, their parties deliver securities or cashto each other, as a guaranty for their obligations under the contract.This process is called “collateralisation”. It does in no way eliminateor reduce the underlying reason for the unwanted credit exposure, itonly mitigates the effect of the exposure. To establish the value ofcash or securities one party has to transfer to the other party, partieshave to agree on the value of the derivative contracts. This can eitherbe done in a multiple of bilateral relationships, or through a centralservice. Cedel Bank in Luxembourg has provided this service. (SeeInternational patent application WO 97/03409, SAMPSON, “Method andsystem for providing credit support . . . ”). For several reasons, thisservice was not accepted by the marketplace and is for the momentdiscontinued. Whichever method is chosen, the collateralisation processincurs a lot of operational costs and operational risk, since the valueof the credit exposure (the sum of the outstanding derivative contracts)and/or the value of the collateral may change in such a way that it nolonger covers the credit exposure.

Another way of addressing the costs of OTC derivatives dealing isclearing. One example of this is a service called SwapClear provided bythe London Clearing House. Counterparties that are members of aclearinghouse may choose to have the clearinghouse stepping in as thecounterpart on both sides of the transaction. By doing this for severaldeals and counterparties, a clearing member can aggregate a lot of OTCderivative deals to the same counterpart and hence get an improvedcredit exposure netting effect. The clearinghouse is also calculating asettlement value on the cleared transactions in order to keep track ofthe net exposure towards their members. Any residual debt or claim issettled daily in cash on a margin account. Some clearinghouses havelately become exempt from capital charges according to the capitaladequacy legislation in many countries. This means that the capitalcosts for cleared deals effectively become close to zero. Someclearinghouses also provide other administrative services where some ofthe operational costs and risks are reduced. The clearinghouses howeverdo not clear all transactions under a master agreement. Hence, thenetting arrangement under the master agreement is broken in two parts,one part that moves to the Clearing House, and another part that staysunder the master agreement. This means that there will be a substantial,possibly even a higher, residual credit exposure under the masteragreement.

Far from all OTC derivative market participants are members of aclearing house and it is only when both parties are members of the sameclearinghouse that a deal can be cleared. When a clearinghouse steps inas the counterpart on both sides of the transaction, the number ofoutstanding deals is doubled. Even for cleared deals, there aresubstantial operational costs and risks associated with the number ofoutstanding deals, both within the clearing house as for its members.They still have to perform reconciliation of the tasks performed by theclearing house as well as other administrative tasks linked to thenumber of outstanding transactions and risk management

It is fair to say that both collateralisation and clearing are curingthe symptoms of the problems and not the cause. The cause of theproblems, be it unwanted credit risk or operational costs and risks, isthe high number of outstanding bilateral contracts in such a size thatthe market risk of the sum of these contracts in many bilateralrelationships is close to zero. However, so far there has been noefficient mechanism to make parties agree on the early termination ofthese unnecessary transactions.

If the aggregated Greeks of all transactions done between twocounterparties are high, the credit exposure will vary a lot as themarket is changing. This sensitivity to the market movements will causeproblems in the sense that credit limits or collateral thresholds mayinvoluntarily be exceeded and that collateral obligations may varycausing a lot of collateral transactions or large movements in themargin account at the clearing house. For this reason, it is desirablefor the counterparties to reduce the aggregated Greeks in theirbilateral transactions.

Operational risk can be defined as all risks an institution is exposedto, other than the intentionally accepted market and credit risk withinthe allowed limits of the bank. This includes, among others, unwantedmarket or credit risk as a consequence of staff errors (on purpose or byaccident) or errors in the risk management systems, fraud by staff,customers or third parties, wrong valuation of transactions based onwrong parameter input, or mistakes in the maintenance of outstandingcontracts during their lifetime (so-called fixings, settlements,assignments, exercises or payments).

Although the majority of transactions has a lifetime of up to 5 years,transactions of 30, 40 or even 50 years do occur as well. A trader orrisk manager, who for some reason is using the wrong valuationparameters, may build up substantial losses over a long period of time.Smaller banks and certainly many end-users are lacking the possibilityto do an independent mark-to-market of their outstanding contracts.

Many high profile mishaps have been published over the years, (even tothe extent that some commentators were seeing all derivatives as “evil”instruments) and this should be considered only as the tip of theiceberg; only the low frequency/high impact accidents are gettingpublicity. The high-frequency/low-impact accidents, of which the totalamount of damage may well exceed that of their published cousins, arefrequently overlooked. Forced by these developments, as well as higherlegal standards, market participants have invested a lot of effort,staff and systems to prevent accidents from happening. Procedures havebeen sharpened, internal regulations improved and rigid control measuresestablished. The overhead cost of dealing has for this reason increaseddramatically, and still accidents do happen from time to time.

The operational risk is a concern for the supervisors of the financialmarkets. There are proposals for introducing capital charges to coveroperational risk. So far, the supervisors have not been able to work outprinciples or a model for how these capital charges will be calculated.The issue is still on the agenda though, and it is likely that any suchmodel will generate capital costs that grow with the number ofoutstanding deals.

In addition to these new types of risks, the acquired market risk maywell be according to the trader's intention. Still bank supervisorsforce the banks to hold capital against market risks as well. Anindividual transaction's contribution to the total market risk, forwhich capital must be held, can be quite complicated to calculate,especially when the banks are using so called proprietary models forthese calculations. However, one method, accepted by the banksupervisors and used by many banks, is based on transforming alloff-balance sheet items, e.g. OTC derivatives, into roughly equivalenton-balance sheet items to calculate the capital cost. In this case, itis possible to assign a capital cost to each individual transaction.

In summary, there is therefore an incentive for banks to try to reducethe costs and risks associated with the OTC derivatives portfolios theyhave build up. An apparent way of achieving this would be to terminateOTC transactions before their designated maturity, preferably in a waythat reduces the bilateral credit exposure. However, in order to make anearly termination the banks involved need to address several importantissues that are summarised below:

Both the original counterparties need to agree to the early termination:it could very well be that one of the parties for certain internalreasons does not want to terminate a particular trade.

The counterparties need to establish that they are talking about thesame trade: for every deal between party A and party B, party A storeshis version of the trade and party B stores his “mirror image” versionof the trade in their respective databases. Both parties typicallyassign their own internal trade identifier to their own version of thetrade. There is in general no common identifier or any central registerof the trade.

The counterparties need to agree on the value of the trade: since eachOTC derivative contract is unique, there is no official valuation of acontract such as by a stock market. Each bank does its own valuationusing its own choice of theoretical valuation model, where the model isbased on certain inputs that are estimated by each bank. With thissubjective method of establishing the value of the contract the parties(banks) normally don't agree on the exact value of any individualcontract.

A bank does not want to change its market risk position: whenever a bankhas an undesired market risk it does a hedge transaction to cover thatrisk. If a termination resulted in creating an undesired market riskposition, the bank would need to make a hedge trade that would eliminatethe advantage of doing the early termination.

A bank does not want to make a large cash payment: a bank with a debt toanother party needs to pay out money in order to reduce or settle thedebt. The debt arising in OTC derivatives is actually a form of cheapfunding for a bank, which means that there is no incentive to repay thedebt prematurely. Conversely, the bank with a claim carries the creditrisk and also has the associated capital costs. This bank would thenlike to see that the other party to the contract repaid their debtearly. This asymmetric benefit means that early terminations involvingthe large cash payments necessary for credit exposure reductions areperceived as being disadvantageous and normally do not happen.

A bank does not want to take the initiative for an early termination:since the value of the contract needs to be negotiated in an earlytermination, the party taking the initiative is at a disadvantage inthis negotiation since they reveal their interest first. The other partycan then require a valuation, which is in their favour.

All these issues explain why early terminations do not happen to theextent that is economically warranted. The situation is thereforesummarised in FIG. 1 in that each bank (financial institution) 10 storesits own version of its trades (transactions) 12, each with its ownidentifiers (attributes) 14 and its own calculated market data 16. Eachbank 10 has an ever-increasing list 18 of such transactions 12. Theproblem of massive build up of such OTC transactions 12 is becoming moreand more significant.

An object of the present invention is to overcome at least some of theabove-described problems.

Another object of the present invention is to provide the meansnecessary for solving each of the above-described issues bothindividually as well as simultaneously, which issues currently preventmassive early terminations of financial contracts such as OTCderivatives contracts.

SUMMARY OF THE INVENTION

The present invention provides a method and system for doing massiveearly terminations of OTC derivatives contracts which thereby solvesmost of the above described problems at their respective roots. Morespecifically, the present invention significantly decreases the numberof outstanding financial derivative transactions between counterpartieswith the aim of lowering the gross and net credit exposure betweencounterparties, and/or to lower operational costs and/or risks and/or toenhance risk-control for each counterparty. The present inventionachieves these desirable results by a process of collecting trade datafrom institutions, linking together different versions of the sametrade, grouping together potential combinations of transactions having alow or zero risk, calculating the aggregated value of each group oftransactions and thereafter selecting the group having the bestaggregated value for execution or assignment, namely the group bestmeeting the party-specified tolerances for the termination orassignment.

The beneficial effect of such a process is that it removes the barriersto mass terminations that have existed previously. The key here is thatthe differences in valuations of the same transaction by each party canbe made insignificant by aggregation of the different valuations (overtypically thousands of transactions) which averages out suchdifferences. In addition, aggregation balances out the risks of changein valuation (Greeks) associated with each individual transaction due totheir selection. Preferably, the net present values and the Greeks oftransactions match in total in such a way that they can considered to berisk-neutral. A risk neutral package of transactions is by definitioninsensitive to differences in valuation parameters. Hence, there is ahigh likelihood that the counterparts will agree on the value of such arisk neutral package. Also the value of such a package is not sensitiveto market movements or when the mark-to-market values were established.Since the package is risk neutral, the market risk position is unchangedand the counterparties advantageously do not need to make any newtransactions to retain their desired market position. The parties arehence more likely to agree to prematurely terminate these transactions.These key features provide the benefit of the present invention to thefinancial institutions, which is significant.

An important part of the present invention is to carry out trade linkingof the different versions of the trades shown in FIG. 1. This isachieved by use of a central site where the relevant trade descriptorsare sent, analysed and linked together on the basis of their attributesand market data. This feature is needed in order to create a viableproposal because consent must be obtained by both parties to an OTCderivative transaction prior to its early termination or assignment andso both parties must be able to recognise the transaction using theirown systems for providing the consent.

According to one aspect of the present invention there is provided asystem for terminating outstanding derivative transactions between aplurality of parties, each transaction being described by a transactionrecord provided by one of the parties to the transaction, thetransaction record including trade details identifying the transaction,the trade details at least specifying two parties to the transaction,the transaction record providing one party's valuation of the netpresent value of the transaction, and at least one risk characteristicof the transaction, the system comprising: a plurality of datainput/output and processing stations for transmitting a transactionrecord from each party; a central processing station; and acommunications network operatively interconnecting all of the stations;wherein the central processing station comprises: linking means forlinking together two transaction records from two different partiesrelating to the same transaction, the linking means being arranged touse a plurality of items of the transaction record to determine recordsfrom different parties corresponding to the same transaction; andcombining means for combining together a plurality of linked transactionrecords to determine a termination proposal for terminating a pluralityof the transaction records prior to their maturity dates, the centralprocessing station being arranged to transmit the termination proposalto the data input/output and processing stations of the parties involvedin the proposal.

According to another aspect of the present invention there is provided amethod of terminating outstanding derivative transactions between aplurality of parties, where each transaction is described by atransaction record provided by one of the parties to the transaction,the transaction record including trade details identifying thetransaction, the trade details at least specifying two parties to thetransaction, the transaction record providing one party's valuation ofthe transaction market value, and at least one risk characteristic ofthe transaction, the method comprising: transmitting transaction recordsfrom data input/output and processing stations of the parties to acentral processing station via a communications network operativelyinterconnecting all of the stations; linking together at the centralstation two transaction records received from two different partiesrelating to the same transaction, the linking step using a plurality oftrade details for each record that uniquely identify the transaction ofthe record; combining together a plurality of linked transaction recordsto determine a termination proposal for terminating a plurality of thelinked transaction records prior to their maturity dates; andtransmitting the termination proposal to the data input/output andprocessing stations of the parties involved in the proposal.

Participating counterparties can set the tolerance-limits on differencesin the net present values, maturity dates and/or one or more of theGreeks in such a way that existing exposures between parties can bereduced or conditionally increased. The termination proposal is producedby the system with the explicit aim of reducing credit exposures andcollateral obligations, or to prevent collateral obligations fromoccurring, or to reach a conditional increase in credit exposure, wherethe aggregated risk of the proposal is minimised. The system alsoproduces a termination proposal, with the aim of reducing thevariability of the exposure.

The system may be arranged to produce legally-binding trade terminationsif all pre-agreed parameters are met. This minimises the need to seekapproval after the proposal has been drawn up.

A termination should be interpreted as follows. It can either be adirect contractual agreement to tear up an existing contract, or toenter into a new inverted contract if there exists a way of legallycancelling two such mirror deals. A termination can also apply betweentwo parties, A and B having the opposite position in a contract, in thecase where a third party has taken the place as the counterpart to boththese parties and the third party agrees to effectively cancel both A'sand B's contracts on request of both A and B. This is also independentof the fact if A and B were the original counterparties in thetransaction.

With the help of the central processing station, the combining togetherstep can be expanded to trilateral or multilateral assignment andtermination proposals. In this case, the chances are even higher to findpackages of transactions that both reduce the net credit exposures andare risk neutral to all involved counterparts. This is due to the factthat when looking at three counterparties A, B and C, in a situationwhere they have circular claims, i.e. where A has a claim on B, B has aclaim on C, and C has a claim on A, all parties can reduce their netexposures by the smallest amount of the claims in question, withouthaving any net cash flow effect. The triangular circular claim can begeneralised to groups of more than three parties. If each bank in such agroup has both debt relations and claims relations to other banks in thegroup, each bank will be a part of at least one circular claim, where acircular claim can have more than three other parties in the circle.

In the bilateral case, reducing the credit exposure means that thedebtor needs to make a cash payment to the creditor. Only the creditorgets a credit exposure reduction. Also, the two parties may havedifferent funding costs and thereby attach different value to cash. Thisasymmetric benefit means that it is more difficult to get the parties toagree to perform credit exposure reducing terminations in the bilateralcase. The multilateral termination proposals where there are circularclaims make the proposal beneficial to all involved parties. Also whenthree or more parties are involved, two parties, A and B, that haveopposite exposures to a third party C, can chose to assign a package ofdeals with C from A to B or vice verse, in order to reduce the exposureto C. The assignment package can also be combined with assignments to afourth party D, where both A and B have the opposite exposures as theyhave to C in such a way that both A and B get a credit exposurereduction. The assignment package can possibly be combined with someterminations between A and B in such a way that the whole package isstill cash and risk neutral for both A and B.

From a large population of counterparts that have dealt with each other,there will be many groups of three banks that have circular claims. Thenumber of sub-groups of three out of a population of N parties isproportional to the third power of N. In such a sub-group of three, thelikelihood is 25 percent that the claims are circular, if the directionof all claims are evenly distributed in the population.

According to yet another aspect of the present invention there isprovided a system for exchanging derivatives related data comprising anumber of data input/output and processing stations, an optional centralstation and a network interconnecting all stations, wherein the partiesinvolved in derivatives related contracts each use a data input/outputstation to send trade details, the mark-to-market values and therisk-characteristics (indicated as Greeks) for transactions done withother parties using the system, through the network to each other or thecentral station, where the system is arranged to generate terminationproposals consisting of packages of existing transactions, which arebeneficial to all involved parties to terminate, according to parametersset by the parties.

According to a further aspect of the present invention there is provideda system for terminating outstanding derivative transactions between aplurality of parties, the system comprising: a processing stationarranged to receive transaction data describing a plurality oftransactions from a plurality of transaction parties via acommunications network, the processing station comprising: a linkingmodule for linking together different versions of the same transactionreceived from different parties to that transaction; an analysis modulefor determining a set of linked transactions between a plurality ofdifferent transaction parties, wherein each transaction party in the sethas both debts and claims towards other parties in the set; acalculation module arranged to calculate an aggregated value of each setof linked transactions and arranged to select the set of linkedtransactions which has an aggregated value within party-specifiedtolerance limits acceptable for executing a termination; and anexecution module for executing a termination of the selected set oflinked transactions.

According to a yet further aspect of the present invention there isprovided a method of terminating outstanding derivative transactionsbetween a plurality of parties, the method comprising: receivingtransaction data describing a plurality of transactions from a pluralityof transaction parties via a communications network; linking togetherdifferent versions of the same transaction received from differentparties to that transaction; determining a set of linked transactionsbetween a plurality of different transaction parties, wherein eachtransaction party in the set has both debts and claims towards otherparties in the set; calculating an aggregated value of each set oflinked transactions; selecting the set of linked transactions which hasan aggregated value within party-specified tolerance limits acceptablefor executing a termination; and executing a termination of the selectedset of linked transactions.

BRIEF DESCRIPTION OF THE DRAWINGS

A presently preferred embodiment of the present invention is nowdescribed by way of example with reference to the accompanying drawings.In the drawings:

FIG. 1 is schematic block diagram showing the prior art situation whereeach bank stores its own version of each bilateral OTC trade which ithas entered into;

FIG. 2 is schematic block diagram of a system for implementing massiveearly termination of OTC trades according to a preferred embodiment ofthe present invention;

FIG. 3 is schematic block diagram showing how the situation shown inFIG. 1 is resolved by the system of FIG. 2;

FIG. 4 is flow diagram showing the method of operating the system ofFIG. 2;

FIG. 5 is block diagram showing the data and workflow processimplemented by the system of FIG. 2 in accordance with the method ofFIG. 4;

FIG. 6 is a schematic block diagram of the functional modules of thecentral computer as shown in FIG. 2;

FIG. 7 is flow diagram showing the steps of the trade linking process ofFIG. 5;

FIG. 8 is schematic block diagram showing how the link between twodifferent parties' versions of the same trade is achieved by the systemof FIG. 2;

FIG. 9 is a flow diagram showing a branching process used in the step ofcalculating of groups of banks as suitable candidates for a possibleunwind process of FIG. 5;

FIG. 10 is flow diagram showing the unwind proposal calculation step ofFIG. 5 which is used to calculate the best unwind proposal given theparty-specified constraints;

FIG. 11 is flow diagram showing the step of relaxing the generalconstraints of the unwind proposal calculation shown in FIG. 10; and

FIG. 12 is schematic diagram showing an example of the delta toleranceson different levels containing aggregated data.

DETAILED DESCRIPTION OF A PREFERRED EMBODIMENT OF THE PRESENT INVENTION

A system for executing early mass terminations of derivative contractsaccording to a presently preferred embodiment of the present inventionis shown in FIG. 2. The system 20 is implemented as a network service inthat the system provides a communications network (the Internet in thisembodiment) 22 connecting institutions 24 trading OTC derivatives with acentral site 26, where a secure transfer of data can take place (DataTransfer). At the central site 26, a central computer 28 is providedtogether with a central database for storing transaction data during themass termination process. The central computer 28 performs most of theprocessing to implement the desired mass early terminations as isdescribed in detail hereinafter. Also, the central computer 28 has builtin communications capability for interacting with the local computersystems 32, 34, 36 of financial institutions 24. At each of thefinancial institutions 24, a respective database 38, 40, 42 is providedfor storing each institution's trades 12, and their respective tradeattributes 14 and market data 16 as shown in FIG. 1.

The basic process provided by the system 20 is illustrated schematicallyin FIG. 3. The system 20 acts to connect together the lists 18 ofapparently disparate transactions received from each of the differentinstitutions 24 at the central site 26 using the trade attributes 14 andmarket data 16 provided. The system 20 generates lists 54 of linkedtrades 50 for each institution 24. Thereafter, the system 20 processesthe linked trades 50 such as to effect proposals for mass terminations,which meet the institutions' specified tolerances 52 and on acceptanceby the involved parties, to execute those proposals for early massterminations of OTC contracts. This process is now described in greaterdetail.

Referring to FIG. 4, a method 60 of implementing the preferredembodiment of the present invention is now described. The methodcommences at Step 62 with the financial institutions 24 each carryingout two data determinations, namely determining the trades 12 (trade andcounterparty related data) and respective tolerances 52 to be used in anunwind proposal involving those trades. Due to the large number oftrades on their books, the institutions 24 generate this data as a list18 of trades and their related data. These lists 18 of trades andtolerances 52 are encrypted and compressed and are then transmitted tothe central computer 28 at Step 64.

On receipt of this data, the central computer 28 decrypts anddecompresses the received data and stores the same at Step 66. Tradesfrom different institutions 24 are then linked at Step 68 using matchingtechniques on the trade details 14, 16. A list of linked trades 54 iscompiled for each institution 24 and the list is then sent at step 68 tothe institution 24 for confirmation that correct matching of trades hasbeen carried out either externally (by a third party) or internallyusing the central computer.

The method 60 continues with receipt of confirmations by the centralcomputer 28 from each institution 24 at Step 70. The central computer 28then carries out a process for determining the best groups of potentialparties to an unwind proposal at Step 72, where three or moreinstitutions 24 are preferably involved. Subsequently, at Step 74, thebest groups of potential unwinds are determined using the tolerances 52which have been specified by each of the institutions 24. The bestpotential unwind is converted at Step 76 into a proposal specifying eachparty to the unwind proposal, and is sent to those parties for approval.At step 78, each institution analyses 24 its proposal and assuming aninstitution 24 agrees with the proposal, this is communicated back tothe central computer 28 as a confirmation of the proposal in Step 80.The central computer 28 collects all of the required confirmations atStep 82 and executes the unwind process at Step 82.

Referring now to FIG. 5, the way in which the above-described method isimplemented using specific parts of system is now explained using apseudo data and workflow and apparatus diagram. For the sake ofconvenience only the processing apparatus at a single financialinstitution 24 is shown in FIG. 5, but it is to be appreciated that thisapparatus would be replicated at each of the participating institutions'local computers 32, 34, 36.

The institute's existing trades are first analysed using conventionalsoftware and these are then filtered at Step to provide lists ofpotential trades. At this stage, the Institution's tolerances, whichwould be acceptable with any set of early terminations, are determined.It is to be appreciated that a bank 24 is trading OTC derivatives for anumber of different reasons. The vast majority of the trades aremarket-making trades, i.e. where the bank 24 is both buying and sellingand trying to make a profit from the bid-offer spread. Once the bank 24has bought a contract and sold an equivalent position, and hopefullymade a profit, they are more than happy to terminate both thesepositions since holding them serves no more purpose and only costs themmoney. Sometimes, the banks enter into OTC derivatives trades for aparticular reason. It could be that they want to hedge a particularasset (like a bond) or in general want to manage the overall interestrate exposure of the bank. In such special cases, the bank 24 normallydoes not want to terminate the trade early, since that would defeat theobjective with the trade.

The filtering step 62 involves the banks separating the trades that theywant to terminate from the trades they want to keep. This is normallyquite straightforward since they typically store these trades indifferent books or portfolios.

An analysis tool 90 is provided for analysing unwind proposals as isdescribed later. The filtered trades and tolerances are exported usingan upload function 92 to a conventional position keeping system 94,which is provided for monitoring the trades or lists of trades which theinstitution 24 considers suitable for early termination (clearly thisneed not be all such trades). The position keeping system 94 alsorecords and monitors the status of all trades. Once a record of theselected trades to be sent has been made by the position keeping system94, the list of selected trades is processed by the extraction function96. Here, Step 64 of method 60 is implemented with the extraction ofreports (lists) for the position keeping system 94, their compression,encryption and sending to the central computer 28. The extractionfunction 96 is implemented using conventional compression and encryptionsoftware, which is suitable for providing the required level of securityfor this data (see Data Transfer section later). Such software is wellknown in the art and requires no further explanation herein. Also thetransmission of this data is carried out using conventionalcommunications equipment (a modem) for which no further explanation isrequired.

The encrypted, compressed data can be transmitted over the Wide AreaNetwork (Internet) 22 using any of a variety of protocols, such ase-mail, File Transfer Protocol, 98 etc. At the central site 26, aconventional communications device including an adaptor 100 is providedfor implementing Step 66 of the method 60. The decrypted anddecompressed data is stored in the central database 30 and is accessibleto the processing function 102 present on the central computer 28 toimplement Steps 68, 70, 72 and 74 of the method 60. The resultant unwindproposal in the form of lists of specific proposed trades for eachinstitution 24 is forwarded to an application server 104 inclusive of aplug-in, which is provided on the central computer 28. The plug-intailors the way in which the application server operates to meet thespecific demands of the system 20. The application server 104 implementsStep 76 of the method 60 securely communicating the proposal over theInternet to the respective institution 24 for consideration andapproval. Whilst not shown, the data is encrypted and compressed in asimilar manner to that described earlier with respect to the extractionfunction 96.

At the institution 24, the proposal is decrypted and decompressed (notshown) in the same way as that implemented by the previously describedadapter 100. The analysis tool 90 is then used to analyse the proposalin accordance with Step 78 of the method 60. When the institution 24gets a proposal back they need to verify the proposal. The reason beingthat the data has passed through a number of processing steps, and thereis a small risk of error in each step. Effectively, the proposal is asubset of the information provided by the institution 24. The subset iscalculated so that it fulfills the institution's tolerances, as well asthose of all other banks being parties to the proposals, simultaneously.The institution 24 only needs to verify that its tolerances arefulfilled and that no error has occurred in the processing of its data.

The institution's local computer 32, 34, 36 then uses conventionalcommunication techniques (e.g. e-mail) to carry out Step 80 of themethod 60. When the application server 104 has received all theconfirmed approvals, in accordance with Step 82 of the method 60, theapprovals are confirmed and the proposal is executed.

Further details of the composition of the processing function 102 arenow provided with reference to FIG. 6. The processing function 102comprises a core processing module 110 and a reporting module 112. Boththe processing module 110 and the reporting module 112 interface to thecentral database 30 to retrieve and store data in order to implementtheir respective functions. The function of the reporting module 112 istwo-fold, firstly to generate a linking report 114 in according withStep of the method 60 for sending out to institutions for verification,and secondly to generate an unwind proposal report 116 for eachinstitution 24 for their approval.

The processing module 110 comprises a console 118 for enabling operatorviewing of progress with the automated process of implementation of themethod 60. The console 118 interfaces to the following five moduleswhich implement the heart of the process (method 60). An import function120, a verify function 122, a link function 124, a claims analysisfunction 126 and a proposal calculation function 128 are provided in theprocessing module 110. The import function 120 is provided forcontrolling the import of data from the institutions 24 using theadaptor 100 in accordance with Step 66 of the method 60. The verifyfunction controls the verification of the genuineness of the receiveddata again using the adaptor 100. The link function 124 implements thelinking (matching) of trades in accordance with Step 68 of the method60. The claims analysis function 126 controls the finding of groups ofpotential parties to the unwind proposal of the linked trades inaccordance with Step 72 of the method 60. The proposal calculationfunction 128 analyses the results of the claims analysis function 126and selects the most suitable group of potential unwinds given thebenefit to all parties concerned and taking into account the specifiedtolerances 52, in accordance with Step 74 of the method 60. Theprocessing module also comprises a data manager 130 that manages themany data interactions between these functions and the central database30.

As has been mentioned previously, the institutions 24 using thenetworked service carry out two basic initial processes. They send intrade and counterparty related data (described in detail later in theData Submission section) and define the tolerance for an unwind proposal(described in detail later in the Tolerances section). The centralcomputer 28, on receipt of this data, then carries out a series ofprocessing tasks. Firstly, the central computer 28 links the receivedtrade information (trades) together (described in detail later in theTrade Linking section) and then verifies the trade data (described indetail later in the Trade Verification section). Then the centralcomputer 28 finds groups of banks suitable for unwind proposals(described in detail later in the Claims Analysis section) andcalculates unwind proposals (described in detail later in the UnwindProposal Calculation section). Finally, the central computer 28transfers the proposals back to the banks involved; and arranges for theacceptance and confirmations of the proposal (described in detail laterin the Termination Confirmation section).

Each of the above-mentioned sections is now described in greater detailbelow.

Data Transfer

The data sent between the participating institutions 24 and the centralsite is of a strictly confidential nature. In order to ensure that nounauthorised access is made to the data, standard procedures for securedata transmission are implemented. Different institutions 24 may havedifferent policies for data transfer over a network so different methodscan be applied for different institutions 24. The methods that areoffered by the central computer 28 include:

-   -   Encryption of data using generally available encryption software        packages like PGP;    -   Using a central FTP site for uploading and downloading the        encrypted files;    -   Using standard e-mail for sending and receiving encrypted files;    -   Creation of a virtual private network (VPN) using generally        available solutions; and    -   Using a secure web server (https) for uploading and downloading        files.

Data Submission

The trades that are considered suitable for unwinding are OTC derivativetrades. The methodology is in principle applicable to any type of OTCderivative. In this preferred embodiment description the use has beenrestricted to single currency interest rate swaps and FRAs for thepurpose of clarity. Other types of derivatives would require that othertypes of trade attributes would be used for linking and other types ofGreeks to be used to assess risk neutrality. Single currency interestrate swaps and FRAs simplify the description since they are primarilyonly sensitive to changes in the level and shape of the yield curve.Hence the only significant Greeks are the deltas with respect to changesin different time buckets of the yield curve. As has been mentionedpreviously, OTC derivative trades are privately negotiated bilateralcontracts, which mean that for every deal between party A and party B,party A stores his version of the trade and party B stores his “mirrorimage” version of the trade in their respective databases. Both partiesassign their own internal trade identifier to their own version of thetrade. There is in general no common identifier or any central registerof the trade. The only way to get information on the trades that areoutstanding is to get the information from the two parties.

The trade related information that the institutions 24 are required tosend to the central computer 28 is listed below:

-   -   The set of trades they are willing and able to terminate;    -   Trade identifying data used for linking (see Trade Linking        section later); and    -   Market data (Mark-to-market value and Delta) used in the unwind        proposal calculation (see Unwind Proposal Calculation section        later)

The linking of trades 12 needs to be confirmed by the institutions 24before the unwind proposal is calculated. This means that there will beseveral transfers of data back and forth to the central site 26. Inorder to relate data in different transfers, each bank 24 is asked toprovide a unique identifier on each trade, which is not changed duringthe process. If the identifier is changed the institution 24 is asked toprovide a translation relating the old identifier to the new identifier.

An institution is normally trading OTC derivatives from differentbranches, subsidiaries, profit centres, departments or books(portfolios). The central computer 28 is arranged to treat these asdifferent trade units, where each trade unit acts as a party in its ownin an unwind proposal. This means that the unwind proposal will fulfillthe tolerances as defined by each trade unit and there can also be atolerance aggregated over all trade units from an institution 24. If aninstitution 24 wants to use the service with different trade units, itshould indicate per trade which trade unit that is responsible for thetrade.

The institutions 24 normally have a bilateral master agreement to whicheach trade is referring. The master agreement sets the legal frameworkfor the bilateral trades and contains clauses that are common to allcontracts. In most legislations, it is enforceable with provisions inthe master agreement that allow for netting the outstanding debttransactions with claims transaction in case the counterparty defaults.This means that, under these circumstances, the credit exposure shouldbe calculated as the net exposure under each master agreement. In somecases, two institutions 24 may have more than one master agreement inplace. If that is the case, the institutions 24 are required to provideinformation by trade on which master agreement it is referring to. Thesystem 20 then ensures that the credit exposure changes from the unwindproposal stays within the tolerance set for each master agreement.

The following trade attributes submitted by the institutions 24 are usedin some form in the linking and unwind calculation process.

Column Name Explanation Comment TRADE_ID Trade identifier Uniqueidentifier on trade CP_ID Counter party identifier MA_TYPE Masteragreement The type of master agreement type relevant for the trade.Example: ISDA, DRV ¹. This field is only relevant if several masteragreements with the same counterparty are used. MA_DATE Master agreementThe date the master agreement was date signed CP_TRADE_ID CounterpartyThe counterparty's unique trade identifier identifier, if available.This helps the central computer in the linking and matching of trades.If not available, the other parameters of the trade can be used.INS_TYPE Type of instrument “Swap ²” or “FRA ³” NOMINAL Nominal amountCURR Currency PAY_REC Payer or Receiver Payer or receiver of the fixedrate. E.g.. “Payer”, “Receiver” or “1”, “0” COUPON_RATE Fixed couponrate Swap rates or FRA rates COUPON_PER Fixed coupon Only required forswaps. E.g. rolling period “6M”, “1Y” DAYCOUNT Fixed coupon Onlyrequired for swaps day count method FLOAT_RATE_INDEX Float Rate indexe.g. “LIBOR⁴” FLOAT_RATE_(—) Float rate e.g. “6M” PER periodFLOAT_SPREAD Spread on floating rate FLOAT_RATE Current Floating Thelast fixing made in this contract, rate excluding spread. TRADE_DATETrade date Date the trade was made START_DATE Start date Start date forinterest rate calculation END_DATE End date End date for interest ratecalculation ROLL_DATE Base date for Only required for swaps with couponsrolling periods NEXT_FIXING_DATE Next Fixing Date See footnote below ⁵NEXT_FLOAT_PAY_DATE Next Floating See footnote below ⁶ Payment DateNEXT_FIX_PAY_DATE Next Fixed See footnote below ⁷ Payment Date MTM_DATEMark-to-market date The date for which the mark-to-market was doneMTM_VALUE_DATE Mark-to-market The date for which the mark-to- value datemarket is calculated MTM_VALUE Mark-to-market The mark-to-market valueis given value in the trade currency, and represents the full economicvalue of the trade (accrued interest is not deducted) MTM_CURR TheMark-to-market The currency in which the mark-to- currency market isexpressed. Only if it differs from the trade currencyDELTA_[{CU}|{DATE}] Delta per time bucket The time buckets (unitperiods) that One column per should be used are the time buckets inbucket. Either which the bank will decide if a package C = Count, U =Unit of transactions is risk neutral. The more e.g. “6M”, or a date.time buckets that are used, the more difficult it will be to find riskneutral unwind packages. DELTA_CURR The currency of the The currency ofthe delta (if the delta values. currency is different from the tradecurrency) ¹ Deutsche Ramen Vertrag or translated “German masteragreement”. This is a template for master agreements developed by atrade organisation for German banks. ² An agreement between two partiesto exchange regular interests rate payments based on an agreed notionalamount for an agreed time period. Normally, in a single currencyinterest rate swap, the parties exchange fixed interest rates againstfloating interest rates. For the floating rates, the actual rate foreach period is determined by the value of an interest rate index likeLIBOR in the beginning of that period. ³ Forward Rate Agreement, anagreement between two parties that the difference between the agreedforward rate for an agreed single future time period and the actual ratefor that period shall be paid by one party to the other, based on theagreed notional amount. The actual rate is determined at the beginningof the period by the value of an interest rate index like LIBOR. ⁴London Inter-Bank Offered Rates, an interest rate index calculated byasking a set of banks what interest rates they are offering to otherbanks, eliminating some of the highest and lowest offers and thenaveraging the rest. The LIBOR interest rates are published daily, for anumber of maturities (e.g. 3 months, 6 months etc) and are frequentlyused by OTC derivatives as a basis for determining floating rates. ⁵Trades that have a fixing or payment date between the data collectiondate and the date the closeout amount should be paid will be excludedfrom the unwind proposal. Overnight index swaps will still be included.⁶ If the bank cannot supply these data fields, the Roll Date and RollPeriods are used to calculate these dates. ⁷ The contracts that has beenre-denominated to EUR sometimes have decimals, sometimes not, hence atolerance of 1 currency unit

The counterparty related data that is required is the counterpartyidentifier used and the aggregated credit exposure for all contractsunder the master agreement used for the trades.

The counterparty related data is given in a table with one row for eachmaster agreement that is in place with the other banks participating inthe project.

Column name Explanation Comments CP_ID Couterparty The same as used inthe identifier Trade table MA_TYPE Master agreement The type of masteragreement type relevant for the trade. Example: ISDA, DRV. This field isonly relevant if several master agreements with the same couterparty areused. MA_DATE Master agreement date The date the master agreement wassigned CP_NAME Descriptive name Optional of the counterparty EXPO_DATEThe date of the exposure calculations EXPO_TOT Total net exposure Theexposure should be given as of all trades under positive for claims andnegative the master agreement, for debts expressed in EXPO_CURREXPO_CURR The denomination currency for EXPO_TOT

Tolerances

Even though there are strong incentives to do unwinds, there are also afew associated issues to be taken into consideration by each party. Eachparty does not want to:

-   -   unwind at an unfavourable value (they don't want to make a        loss);    -   pay out large amount of money;    -   change their risk profile (delta per time bucket); or    -   increase their credit exposure to a counterparty

For each of these considerations there is normally a tolerance beneathwhich an institution is willing to do an unwind. When checking thesetolerances, each party will usually insist on using their own assessmentof the value and risk of the trades.

In general, these tolerances are so tight that any individual trade doesnot meet them. Unwinding is only possible when a package of transactions(a collection of trades) is built where the package in total fulfillsthe tolerances. In order to construct such a package, it is in mostcases necessary to make some partial terminations. However, the partiesdislike partial terminations and hence, in the present embodiment thereis a tolerance set for how high the ratio of partial terminations can bein relation to the full terminations.

Profit & Loss Tolerances

In order for a financial institution to find the unwind proposalacceptable, any losses should be limited. Each institution thereforedefines a loss tolerance, which can be set to zero.

Delta Tolerances

The financial institutions 24 provide a market risk tolerance, i.e., aresidual delta that can be accepted as risk neutral for each includedcurrency. This double-sided tolerance (+/−) represents a risk that thebank, under normal circumstances, does not consider to be big enough tobe worth hedging.

The delta tolerances may be set on up to four time bucket aggregationlevels:

-   Level 1: Total delta tolerance 0 to 50 years;-   Level 2: Twist tolerances 0 to 5 years and 5+ years;-   Level 3: Skew tolerances 0 to 2 years, 2 to 5 years, 5 to 10 years    and 10+ years; and-   Level 4: Time bucket tolerances (according to a set of time buckets    selected by each bank).

The purpose of having four levels for the delta tolerance is to ensurethat there are no unfavourable accumulation effects over the differenttime buckets. Assume, for example, that an institution allows a deltatolerance of 10 000 EUR per time bucket they use. Assume as well thatthey are using 20 time buckets. In the worst case, the deltas of theunwind proposals could all be in the same direction and have a level of10 000 which would then create a total delta of 200 000 EUR. Thetolerance levels 1, 2 and 3 ensure that accumulated delta effects arelimited and, hence, that higher tolerances can be given on the4^(th level.)

The first three levels also capture the majority of the interest raterisk in the proposal. It is not required to set tolerances on all fourlevels. For example, an institution can choose not to set any toleranceson level 4, thereby allowing more delta variations between twoneighbouring time buckets.

A detailed example of a delta tolerance on multiple levels is providedlater with reference to FIG. 12.

Partial Unwind Tolerance

As more partial unwinds are allowed, the chance of creating an unwindproposal that meets all other tolerances increases. Obviously, makingpartial unwinds increases the workload when actually executing theunwind proposals. A tight partial unwind tolerance also means that a lotof full unwinds cannot be executed. The reason for this is that thepackage (group) needs to fulfill the delta tolerance per bucket, so inbuckets where there are only a few trades all of them may need to bekept to avoid getting a partial unwind. So, there is a trade-off betweengetting a large number of full unwinds and getting a few partialunwinds.

The tolerance for partial unwinds is given as the number of completeunwinds per partial unwind. For example, a partial tolerance of sevenmeans that seven or more full trades must be unwound for each partialunwind.

Maximum Cash Amount To Receive Or Pay

The unwind proposals are required to be approximately cash neutral. Theinstitutions 24 are requested to express the tolerances of paying andreceiving cash. The amounts are given in one currency as the totalequivalent cash amounts in all currencies to either pay or receive.Maximum Increase of Credit Exposure

The system 20 will try to reduce credit exposures as much as possibleusing groups of institutions 24 having both claims and debts to eachother.

A far greater number of transactions can be terminated if a small creditexposure tolerance is permitted for use in

-   -   Switching credit exposures between two counterparties    -   Increasing credit exposures on some counterparties

The credit exposure tolerance should indicate the maximum increase incredit exposure per party.

Trade Linking

An early termination of an OTC derivative trade requires the consent ofboth parties in the trade. It is therefore required that both partieshave submitted their version of the trade to the central computer 28 forunwind processing. The central computer 28 establishes that this is thecase by finding and linking the trades that both parties have submitted.Since there is in general no common identifier, the central computer 28uses the other attributes 14, 16 of the trades 12 in order to see ifboth parties have sent in their version of the same trade 12. This isdone in a process called trade linking.

Matching services are known that provide matching and linking of dealsat the moment they are done. SWIFT Accord for example, provides such amatching service. For matched trades there is a common identifier and inthat case this common identifier is used for the linking of trades.

More specifically, referring to FIG. 7 the trade link process commenceswith the reception of trade and market data at Step 150 from each of theparties wishing to use the system 20. The central computer 28 thenanalyses the data (attributes and market data) for each trade and linkstogether different versions of the same trade at Step 152 using aprocess of matching the received trade describing data. In the presentembodiment, the matched trades are compiled into a link report one foreach party sending in trades and sent at Step 154 to each relevantparty. The parties analyse the link reports and send back theirconfirmations that the linking has been carried out correctly. Theseconfirmations are received at Step 156 and are used in Step 158 toupdate the link status. Once this has been achieved the link processends at Step 160.

Referring now to FIG. 8, the way in which the two versions of the sametrade are linked together by the central computer 28 is shown. Eachversion of the trade has an identifier 170 for the party, anotheridentifier 172 for the counterparty and a local trade identifier 174.Whilst local trade identifiers 174 are different, the process at thecentral computer 28 creates a trade link 176 with a unique link ID 178to identify the two linked versions of the trade.

In the trade linking process the key financial terms of the deals areused to identify the trade. The key financial terms are different fordifferent types of OTC derivatives, but for swaps the followingattributes are used:

-   -   The counterparties    -   The nominal amount    -   The currency    -   The end date    -   The fixed coupon    -   Pay or receive of the fixed coupon

In addition several other attributes can be used, but practically, it isvery unlikely that two counterparties have dealt two identical trades(in terms of the attributes listed). Even if they have, the contractsare normally identical which means that any ambiguity can easily beresolved by just picking one pair of the matching trades.

Link Status

The initial linking process operates on the trade data submitted andproduces a list of trade links having one of the following statuses:

-   -   Tentative    -   Suspected    -   Ambiguous

A ‘Tentative’ link is a link between two records that basically match inall the compared fields (as defined below) and thereby with very highlikelihood refers to the same original transaction. A ‘Suspected’ linkis a link between two records that basically match in all the comparedfields but where some minor error requires further attention. An‘Ambiguous’ link is a link where several records match in the comparedfields. The list of initial links is send to the involved parties andthe parties are asked to verify and confirm the links. For each link inthe list, the parties are asked to indicate whether there is a match ornot. This is indicated by changing the status to:

-   -   Confirmed    -   No Match

The unwind process then only uses the trade links in status ‘Confirmed’.

Compared Fields

The following fields are used in the trade record comparison. (Detailedexplanation of the fields, provided in Data Submission section.)

-   -   CP_ID (counterparty identifier)    -   CURR    -   NOMINAL    -   PAY REC    -   FIXED COUPON    -   FIXED ROLL PERIOD    -   FLOAT RATE INDEX    -   FLOAT RATE PERIOD    -   FLOAT RATE SPREAD    -   END DATE

These fields either must match exactly or within a certain tolerance.The fields also have a certain difference factor as described below. Thelinking algorithm calculates a total difference factor for allcombinations of two trades sent by two counterparties. The totaldifference factor is calculated by summing the difference factors fromthe individual fields, when they deviate more than the tolerance. Then,there are limits defined on the total difference factor for giving aclassification as ‘Tentative’, ‘Suspected’ or ‘Ambiguous’. For fieldshaving more than one tolerance, the one with the highest differencefactor is tested first.

Field Tolerance Difference factor CP_ID None Infinite CURR None 0.45NOMINAL >1 currency unit ⁸ 0.45 FIXED_COUPON >0.0001% 0.45 >0.000001%0.01 FIXED_ROLL_PERIOD None 0.02 FLOAT_RATE_INDEX None 0.05FLOAT_RATE_PERIOD None 0.01 FLOAT_RATE_SPREAD >0.0001% 0.02 END_DATE >4days (unadjusted) ² 0.5  >2 days (business 0.5  day adjusted) >0 0.01 ²Some banks store business day adjusted end dates, others unadjusteddates.

Comments

The fields CP_TRADE_ID, TRADE_DATE and START_DATE are not used in tradelinking since the experience shows that many banks change these fieldsin situations like systems migrations, trade re-denominations etc.

All banks need to supply translation lists for how they denotecounterparty ID, float rate indices and daycount conventions. Experiencehas shown that it is quite difficult to get to any agreement on daycountconventions, since many banks find it hard to translate their internalcodes to a standard format. For this reason, daycount method is also notused in the trade linking process.

Classification of Link Status

In order to qualify as a ‘Tentative’ link, all fields have to be withinthe tolerances, i.e., the total difference factor should be 0.0. Inorder to qualify as a ‘Suspected’ link, the total difference factorshould be less than 0.1. If several trades have the same totaldifference factor and qualify as Suspected, they are marked as‘Ambiguous’.

With the difference factor set as above this means that the fields usedin the linking can be divided in two categories:

-   -   Major attributes—Counterparty, currency, nominal, fixed coupon        and end date    -   Minor attributes—rolling periods, float rate index and spread

In words, the linking criteria can then be described as:

-   -   If the one of the major attributes did not match, there is no        match.    -   If only a few of the minor attributes did not match or if some        of the major attributes deviated, but less than the tolerance,        there was a suspected match.

The linking of trades is then tested during the trade verificationprocess.

Trade Verification

The central computer 28 verifies the data sent by the banks. This testis done after the linking of trades and on all subsequent datatransmissions in order to detect any mistakes in the valuations. Thetest is carried out by comparing how many interest rate basis points(abasis point is 0.01%) the mark-to-market values are apart.

This is done by dividing the difference in the mark-to-market valuationby the total deltas as supplied by the parties. The delta is normallyexpressed as the change in value of a contract given a basis point shiftin interest rates. The following tolerances are used to filter outpossible suspected errors:

Remaining maturity Tolerance in basis points <1 month 15 <6 month 8 <1year 5 1 year + 3

Claims Analysis

The purpose with the claims analysis is to find groups of banks forwhich an unwind proposal should be calculated. The selection criteria isthat the banks in such a group should have both claims and debts towardseach other, and ideally the sum of the claims should equal the sum ofthe debts for each bank. If that is the case, the potential for creditexposure reduction is maximised.

The number of ways of selecting groups of banks grows quickly the largerthe population to select from and the larger the group being selected.However, the OTC derivative trades are bilateral which means effectivelythat each bilateral relationship only needs to participate in one unwindproposal at the time. When a bilateral relationship has been used in anunwind proposal it will be exhausted and it will take some time ofcontinued trading before a sufficient number of new trades have beenmade in order to make it possible for that bilateral relationship totake part in a new unwind proposal.

The selection process is therefore focused on selecting which bilateralrelationships rather than which parties that should take part in anunwind proposal. To clarify, even if both bank A and bank B take part inan unwind proposal X it does not necessarily mean that the tradesbetween bank A and bank B are used in the calculation of the unwindproposal X. Instead, bank A and bank B can also be parties in unwindproposal Y where the trades between A and B are used.

To be even more specific, the credit exposure reduction needs to befound in relation to each master agreement. This means that theselection process is focused on finding the set of master agreementsthat should take part in an unwind proposal. A master agreement takingpart in an unwind proposal means that the OTC derivative contractsreferring to that master agreement are used in the calculation of theunwind proposal. The vast majority of banks only have one masteragreement with each counterparty under which they trade swaps so inpractical terms the master agreements can be thought of as bilateralrelationships.

The number of bilateral relationships in a group of banks is equal ton*(n−1)/2 where n is the number of banks. For example if n=100 thenumber of bilateral relationships are 4950 (100*99/2).

In the selection process other issues need to be taken into account inaddition to the bilateral claims. The total number of trades in eachproposal needs to be manageable for each bank. In practical terms thismeans that the number of trades per bank should not exceed a fewthousand. On the other hand, efficiency in terms of the ratio of fullyunwound trades to the total amount of available trades increases themore trades there are to work with in an unwind proposal. This meansthat each bank should have at least a few dozen trades with the otherparties in a proposal in order to make it worthwhile to participate.

The Exposure Matrix

The credit exposures sent in by the institutions 24 are summarised in anexposure matrix. The banks are ordered in an unambiguous way and eachbank is assigned the ordinal number according to this ordering. Theexposure matrix is a square matrix having the same number of rows andcolumns as the number of banks participating. In a cell on row i andcolumn j of the matrix the claims or debts according to the bank withordinal number i towards the bank with ordinal number j are noted. Theclaims are entered with a plus sign and the debts with a minus sign. Thebanks do not in general agree on their credit exposures so any claim ordebt that bank A thinks it has on bank B is in general not equal tominus what bank B thinks it has on bank A. In case two banks have morethan one master agreement, a third dimension in the matrix is opened andindexed with k where k can have the values from 1 to the number ofmaster agreements which are ordered in an unambiguous way.

The matrix for a single master agreement may look something like thatset out in Table X:

TABLE X Parties A B C D A 0 −4 3 1 B 4 0 −2 3 C −3 2 0 −2 D −1 −3 2 0

Reading from the row of party A it can be seen that A has a claim on Cof 3. Inversely, reading from the row of party C, it is apparent that Chas a debt to party A of −3. The matrix is hence approximatelyanti-symmetric in the sense that a[i,j]=−a[j,i]. This is onlyapproximate since the parties may have different opinions on the valueof their existing bilateral deals.

In case the parties have different opinions about the exposures, thecentral computer 28 can work with the non-disputed amount, i.e. thesmallest exposure value in absolute terms, i.e. a value that is not indispute. Working with the non-disputed amount guarantees that the matrixis anti-symmetric, i.e. that a[i,j]=−a[j,i]. In case both parties thinkthey have a claim on each other or both parties think they have a debtto each other, the non-disputed amount will be zero.

In case a bilateral relationship is not to be utilised in an unwindproposal, this can be indicated by having an availability matrix of thesame size as the exposure matrix where a value of 1 indicates that therelationship should be considered or 0 to indicate that the relationshipshould not be considered. In case a bilateral relationship has recentlybeen used in a proposal, and therefore there are only a few transactionsleft, that relationship is marked as unavailable.

Finding suitable groups of banks involves the following tree branchingprocess 180, which is now described with reference to FIG. 9. Theprocess 180 is described in detail in FIG. 9, such that the step-by-stepimplementation of the tree branching process can be carried out.However, for the sake of convenience, the following general descriptionof the tree branching process 180 is provided in the text for ease ofunderstanding.

The process 180 starts with the first party putting themselves as theroot node of a complex tree branching process. The columns on thatparty's row are looked through in order to find other parties where thisbank has an available claim. When a claim is found in a column, thatbank's name is placed in a node on level two of the tree. That party'srow is then considered for other available claims. When a new availableclaim on that row is detected, the third party is placed in a node inposition three of the tree. From the third party and onwards, thealgorithm also starts looking to see if they have a claim on the bank inthe first node in the tree. If so, the group of banks has both claimsand debts towards each other and is a valid candidate group for unwindproposals. The process 180 then continues to look for parties that haveclaims on others and whenever a claim exists on the first party in thetree, or if such a claim has already been encountered, on any of thepreceding parties in the branch, a valid group is found. The validgroups are then stored.

When the process has been completed for the first bank, all possiblegroups involving the first bank have been found. Continuing with theother banks in the first position, it is apparent that any treebranching that leads to the first bank can then be terminated since itwill be a duplicate. The fact that most branches get terminated longbefore all possible claims are tested, means that the number nodes tosearch is reduced significantly. Also, the fact that only a fraction ofthe possible bilateral relationships are available in each round alsoreduces the number of nodes and branches.

A non-limiting example to clarify the above-described tree branchingprocess 180 (algorithm) is now set out below:

First the algorithm starts with bank A and puts them in a node in thefirst position.

-   -   1) A

From the exposure matrix, the algorithm determines that A has claims onC and D, which are put in the second position

-   -   1.1) A−C    -   1.2) A−D

Continuing with the first open branch, C only has a claim on B, which isthen put in the third position

1.1.1) A−C−B

-   -   1.2) A−D

B then has a claim on A and D. The fact that A appears means that thegroup ABC has both claims and debt to each other. This is marked thiswith a star (*) in the diagrams below. This group is stored in the validgroup list.

-   -   1.1.1.1) A−C−B*−A!    -   1.1.1.2) A−C−B−D    -   1.2) A−D

Since B had a claim on A it then the fact that D has a claim on C meansthat the group ABCD also is valid and it is stored in the valid list.There are no more claims to analyse for D on level 4, which is markedwith an exclamation mark (!) as shown below.

-   -   1.1.1.1) A−C−B*−A!    -   1.1.1.2) A−C−B−D*!    -   1.2) A−D

The algorithm continues with 1.2) and finds that D has a claim on C.

-   -   1.2.1) A−D−C

-   C then has a claim on B.    -   1.2.1.1) A−D−C−B

The algorithm also determines that B has a claim on A, which means thatABCD is valid. When the algorithm tries to store ABCD it determines thatthis group has already been stored in the valid list so the branch ofthe tree is dropped.

At that point, A in the first position has been exhausted and all validgroups involving A have been found. This means that whenever a branchwith a node that has already been exhausted is encountered, that branchis dropped.

Continuing with B in the first position, the algorithm provides:

-   -   2) B

B has claims on A and D, where the branch with A is already exhausted soit is dropped which is marked with a plus sign (+):

-   -   2.1) B−A (+)    -   2.2) B−D

D then has claims on C

-   -   2.1) B−A (+)    -   2.2.1) B−D−C

And C has claims on B, so BCD is put in the valid list.

-   -   2.1) B−A (+)    -   2.2.1) B−D−C *

With only two parties remaining to be explored in the first position,there are no more possibilities to find valid groups that have not beenfound before so the process is stopped.

As a summary, at the end point the algorithm has determined thefollowing branches and valid groups:

-   -   1.1.1.1) A−C−B*−A!    -   1.1.1.2) A−C−B−D*!    -   1.2.1.1) A−D−C−B!    -   2.1) B−A (+)    -   2.2.1) B−D−C*!

The valid groups are ABC, ABCD and BCD.

The process above will generate all possible groups where there are bothclaims and debts towards each other. However, the same bilateralrelationship may appear in many groups. In theory, the same relationshipcan be used in several proposals but in practise, the chance ofconfusion and mistakes are higher so it is in general avoided. In orderto find the best groups they can be ordered along any of twocriteria—the reduction number and the number of trades.

For each group, there will be a reduction number, representing theexposure reduction possible in the group. The reduction number iscalculated in the following way. Calculate the sum of all claims and thesum of all debts for each bank towards the other participants in thegroup. The reduction number for a bank in a proposal is the smallestabsolute value of the sum of the claims and the sum of the debts. Thereduction number for the proposal is the sum of the reduction numbersfor each bank in that proposal.

For each valid group, the number of trades that are available for theunwind calculation can be determined. As noted above, there are forpractical considerations a floor and a ceiling on the suitable number oftrades for each bank in each proposal, which means that many validgroups can be filtered out of further consideration.

As the same relationship should not be used on more than one proposal,groups that contain the same bilateral relationship as a group alreadyselected are also filtered out of further consideration.

Unwind Proposal Calculation

Once the group of banks that should participate in an unwind proposal isselected, the actual unwind proposal calculation can start as is nowdescribed with reference to FIGS. 10 and 11.

Since unwinding is done using linked trades, the package of transactionsin the unwind proposal must simultaneously fulfill all involved parties'specified tolerances. This also means that the unwind proposal must beaccepted by all parties simultaneously and in full. If one party rejectsthe proposal, the whole proposal is rejected. If one trade in thepackage is removed, the proposal will (most likely) no longer fulfillall tolerances. Hence, there is no possibility to alter the proposal byremoving individual trades. The proposal also contains a net close outamount to be paid or received by each party. This close out amount is apart of the proposal and cannot be negotiated.

In order to find a package of trades that fulfills all involved party'stolerances simultaneously, all tolerances must be incorporated into thesolution algorithm. At the same time the objective is to find a packagewhere as many full trades as possible are terminated. Typically, thisresults in each selected proposal not having more than five to sevenparties, otherwise the proposal can get too complicated and inefficient.Thereafter, the largest set of trades that fulfill all parties'tolerances is determined for the proposal. The first step is necessaryas there may typically be hundreds of parties subscribing to the networkservice. Eventually, it is desired to cover all bilateral relationshipsin a proposal. However, how the groups are selected affects the amountof credit exposure reduction than can be achieved (this method has beendescribed above in the claims analysis section).

The problem is of the nature of “constrained optimisation”. Theconstraints and the optimisation goal function are linear which meansthat a standard method for linear programming can be used. Accordingly,the first step of the Unwind Proposal Calculation process 250 at step252 is to solve this Linear programming problem. This is solved as isdescribed below.

A linear programming (LP) problem is of the form:

-   -   maximize c^(T) x    -   subject to    -   lv≦x≦uv    -   lt≦Ax≦ut,        where    -   x, c, lv and uv are n element vectors,    -   lt and ut are m element vectors    -   A is an m by n matrix.    -   n is the number of variables    -   m is the number of general constraints

There are a vast literature and a number of standard software packagesavailable for the solution of linear programming (LP) problems. Adetailed description of a solution method for linear programmingproblems can be found in “Dahlquist, Björck, Anderson (1974) NumericalMethods Prentice Hall, Englewood Cliffs, N.J.”. The following exemplarydescription is only intended to show how the unwind proposal calculationproblem is formulated as a standard LP problem.

In order to formulate the unwind proposal calculation problem as alinear programming problem, all the linked trades and the tolerancesshould be ordered in an unambiguous way so that each linked trade andeach tolerance gets a unique ordinal number.

In this particular case, the variables (x) will be the part of thelinked trades that will be terminated. A value xi=1.0 then means thattrade number i will be completely terminated. A value xi=0.0 means thatthe trade should be kept on the books as it is. A value xi=0.5 meansthat the trade should be partially terminated to 50% which is done bychanging the nominal amount of the trade to 50% of its current value.

Each variable must be less or equal to 1.0 since more than a full tradecannot be terminated. Each variable must also be greater than or equalto 0.0 since a negative value would mean that the parties holdings of anexisting trade would increase. In the LP problem case this means thatall elements of the vector lv should be 0.0 and all elements of thevector uv should be 1.0.

The element of the vector c is the weight each linked trade has in theoptimisation goal function. The absolute value here is of no concern,only the relative values between the elements are important. In case alltrades should be weighted the same, all elements of c can be put to 1.0.In case the optimisation should try to terminate as many long dated andlarge trades as possible, the value of ci could be set to the remainingtime to maturity multiplied by the nominal amount of the trade i.

The elements in the matrix A and vectors lt an ut are found by thefollowing procedure. Each tolerance defined by each party willconstitute one row in the matrix. For example, if bank A has set a totaldelta tolerance of +/−3 000 EUR and this tolerance has been assigned theordinal value j, the value of ltj will be −3000 and the value of utjwill be +3000. The matrix values Aij will be the total delta of trade ias calculated by bank A in case bank A is a party in trade i. If bank Ais not a party of trade i, Aij will be zero.

The double constraints lt≦Ax≦ut can be reformulated as two normal singleconstraints like:

-   -   Ax≦ut    -   −Ax≦−lt

One-sided tolerances, i.e., where there is either just a lower bound oran upper bound, are handled by ignoring the corresponding singleconstraint. This reformulation will be denoted as:

-   -   BX≦u

Where B is an M by n matrix where M is the number of applicable singleconstraints. These inequalities will be called the general constraints.For the purpose of reducing the number of partials, the right handvector u will be multiplied with a scale factor as described later. Theconstraint above is equal to:

${{For}\mspace{14mu} {all}\mspace{14mu} j} = {{1\mspace{14mu} {to}\mspace{14mu} M\text{:}\mspace{14mu} {\sum\limits_{i = 1}^{n}{{Bij}*{xi}}}} \leq {uj}}$

Once the LP problem has been solved, the next step in the UnwindProposal Calculation process 250 is to remove the scale factor from thegeneral constraints at Step 254. The way in which this is carried out isexplained in detail later with reference to FIG. 11, which shows thisstep in detail.

Reducing the Number of Partial Terminations

In realistic situations, the solution of the LP problem above will bethat most trades will hit the constraint=1.0, i.e. that they should becompletely terminated. However, there will also be many trades that arepartially terminated since the optimisation goal function favours asolution where a trade is terminated to 20% compared to not beingterminated at all. Since the value for the banks of a partiallyterminated trade normally does not exceed the cost of handling thepartial termination, this is an unsatisfactory solution. It could alsobe that the number of partials in relation to the number of full unwindsis so large that the partial tolerance is not fulfilled. In order toreduce the number of partial terminations the following procedure can beapplied.

Starting from the solution of the LP problem above, a new reformulatedLP problem can be defined as is described in Steps 256, 258 and 260 ofthe Unwind Proposal Calculation process 250 of FIG. 10. In thisreformulated LP problem, only the partially terminated trades areconsidered as variables. In the reformulated problem, the optimisationproblem consists of either lowering at Step 256 as many partials back tozero as possible (“push down”) or increasing at Step 258 as manypartials up to 1.0 as possible (“push up”). When pushed down to 0.0 orincreased to 1.0 they are no longer partial terminations. Thereformulated problem can be performed iteratively by checking at Step260 whether any partials remain and if so repeating the push down andpush up steps 256, 258. Accordingly, in each step there is alternationbetween the push down and the push up optimisation problem and each steponly uses the remaining partially terminated trades from the step beforeas variables.

More specifically, each iteration of Steps 256 and 258 comprises thefollowing steps:

A new variable yk is defined for all variables xk that where partial,i.e. 0<xk<1.0. In the push down case, variable xk is substituted withxk(1−yk). In the push up case variable xk is substituted withxk+yk(1−xk).

As can be seen, a value of yk=0.0 leaves all xk unchanged. A value ofyk=1.0 brings xk to 0.0 in the push down case and xk to 1.0 in the pushup case. In both cases, xk no longer represents a partially terminatedtrade.

The reformulated problem consists of maximising:

-   -   maximize c^(T y)    -   subject to    -   0≦y≦1.0    -   B′y≦u′,

Where c and y are np element vectors and np is the number of partials.The optimisation function (the vector c) can still have all elements setto 1.0. The constraints 0≦y≦1.0 ensure that x also fulfills thetolerances 0≦x≦1.0. The matrix B′ only contains the rows where thepartially terminated trades had non-zero elements and the elements ofthe matrix are found by the following derivation:

Push Down

$\left. {{\sum\limits_{i = 1}^{n}{{Bij}*{xi}}} \leq {uj}}\Rightarrow{{{\sum\limits_{partials}{{Bij}*{xi}}} + {\sum\limits_{nonpartials}{{Bij}*{xi}}}} \leq {uj}} \right.$

{Substituting xi→xi(1−yi) where xi is partial}=>

$\left. {{{\sum\limits_{i = 1}^{np}{{Bij}*{{xi}\left( {1 - {yi}} \right)}}} + {\sum\limits_{nonpartials}{{Bij}*{xi}}}} \leq {uj}}\Rightarrow{{\sum\limits_{i = 1}^{np}{{- {Bij}}*{yi}}} \leq {{uj} - {\sum\limits_{i = 1}^{n}{{Bij}*{xi}}}}} \right.$

So the new element in B′ and u′ becomes

B^(′)ij = −Bij${u^{\prime}j} = {{uj} - {\sum\limits_{i = 1}^{n}{{Bij}*{xi}}}}$

Push Up

$\left. {{\sum\limits_{i = 1}^{n}{{Bij}*{xi}}} \leq {uj}}\Rightarrow{{{\sum\limits_{partials}{{Bij}*{xi}}} + {\sum\limits_{nonpartials}{{Bij}*{xi}}}} \leq {uj}} \right.$

{Substituting xi→xi+yi(1−xi) where xi is partial}=>

$\left. {{{\sum\limits_{i = 1}^{np}{{Bij}*\left( {{xi} + {{yi}\left( {1 - {xi}} \right)}} \right)}} + {\sum\limits_{nonpartials}{{Bij}*{xi}}}} \leq {uj}}\Rightarrow{{\sum\limits_{i = 1}^{np}{{Bij}*{{yi}\left( {1 - {xi}} \right)}}} \leq {{uj} - {\sum\limits_{i = 1}^{n}{{Bij}*{xi}}}}} \right.$

So the new element in B′ and u′ becomes:

B^(′)ij = Bij(1 − xi)${u^{\prime}j} = {{uj} - {\sum\limits_{i = 1}^{n}{{Bij}*{xi}}}}$

When the solution y to the reformulated push up/push down problem hasbeen found, the values for y are back substituted for x by:

Push Down: x_(inew)=x_(iold)(1−yi)

Push Up: x_(inew)=x_(iold)+yi(1−x_(iold))

Whenever the solution for yi is 1.0, the value for x_(inew) will be 0.0in the push down case and 1.0 in the push up case. If so, the number ofpartials has been reduced and a new iteration can be made.

At Step 260, if no partials have been eliminated during two consecutivepush up/push down iterations the iteration procedure stops at Step 262.

The alternating push up/push down procedure is very efficient inreducing the number of partials. The efficiency can be further improvedby tightening the general constraints in the original problem as iscarried out by Step 254 (mentioned above) and shown in FIG. 11. This isdone by scaling the general constraints with a factor smaller than 1.0.This scaling is removed in the partial reduction algorithm. This leavessome slack in the constraints which makes it easier for the partialreduction algorithm to transform partials to fully terminated or fullykept trades.

The process commences by setting a scale factor of 0 and an index valueof 1 at Step 270. The scale factor is applied to the general constraintsat Step 272 and the best proposal is calculated at Step 274. If theproposal is a valid one, it is stored at Step 276. Subsequently, theindex is incremented and the scalefactor reduced to 1.0 minus 5% of theindex at Step 278. If the index number has not exceeded 10 (checked atStep 280) the new scalefactor is used and Steps 272 to 278 are repeated.This has the effect of trying out several different scaling factors andfor each scaling factor, the ratio of full unwinds to partial unwinds iscalculated. Then a check is made to determine whether any validproposals exist at Step 282. If there is more than one scaling factorthat fulfills the partial unwind tolerance ratios, then at Step 284, thescaling factor giving the largest number of fully terminated trades isselected for use in the final solution and the general constraintsrelaxing Step 254 ends at Step 286.

If no scaling factor gives a solution that fulfills the partialtolerances as determined at Step 282, the number of constraints must bereduced. This is achieved by eliminating trades from the originalproblem at Step 288 that contribute to constraints that are hard tofulfill without partial terminations. Typically, this will be tradeswith a long time to maturity and therefore having delta values inlong-dated buckets. The number of trades that mature in each bucketgenerally becomes smaller the further in the future the bucket is. Thismeans that it can be hard to fulfill the delta tolerances for long-datedbuckets with a sufficient ratio of partials to full unwinds. Eliminatingsuch trades from the original LP problem at Step 288 means that thesetrades will not be considered for unwinding, i.e. they will be kept onthe books. After the elimination step, if there are any more tradesremaining (as determined at Step 290), the process of relaxing thegeneral constraints is repeated as can been seen in FIG. 11. Otherwise,the process ends at Step 286. The elimination of trades continues untila solution that fulfills all tolerances including the partial toleranceis found or until all trades have been eliminated in which case thereexists no non-trivial solution to the unwind calculation problem. Suchnon-existence of a solution only occurs when there are a small number oftrades and tight tolerances.

Termination Confirmation

Since all parties to an unwind proposal need to accept the proposal inorder for it to be valid, a multilateral confirmation procedure isrequired. The confirmation procedure in the OTC derivatives market isnormally divided in two phases; one acceptance phase and one writtenconfirmation phase. The deal is binding after the acceptance; thewritten confirmation phase is for the record of the transaction only.

There are several ways of arranging an acceptance:

-   -   1. multilateral telephone conference    -   2. an agent collecting each bank's acceptance and when all are        collected the agent notifies all parties that the proposal is        confirmed

Telephone Conference

The telephone conference is arranged by sending out contact details likephone number and scheduled time together with the unwind proposal. Atthe scheduled time all parties to the proposals should call into thephone conference. During the phone conference, all parties should statetheir names, the bank they are representing and that they accept theunwind proposal. The advantage with the phone conference is that it istechnically simple and conforms to the standard method of dealing on theOTC derivatives market. The disadvantage is that the procedure requiresall parties to participate synchronously, which will be increasingdifficult the more parties there are to a proposal.

Collection of Acceptances By An Independent Agent

Acceptances can be collected by a named agent where banks should providetheir acceptance within a defined deadline. If all banks have acceptedby the deadline, the agent sends out an acceptance notification to theparties. The acceptances from the bank can be done in several differentways like:

-   -   telephone call    -   fax    -   toggling of a button on a web site

In all cases, it is required that the parties have identified themselvesand the bank they are representing. In the telephone case, this is doneby stating the required information, and the agent ensures that thephone call is recorded. In the fax case, the fax should be signed. Inthe web site case, all banks should be provided with a username and apassword that must be given before the acceptance can be made.

Returning now to the issue of delta tolerances on different levels asdescribed previously, a typical example of how a bank would configuretheir tolerances using this mechanism is now described with reference toFIG. 12.

In this example, the bank has chosen to calculate delta separated on 24time buckets, as can be seen in the leftmost column of the table (“2DAY, 1 MONTH, 2 MONTH” etc). For each of these user-defined timebuckets, i.e. on level 4, they allow for a delta in the proposal with anabsolute value of 16000 EUR. However, if the delta of the proposal hadthe same sign and the maximum tolerated value of either +16000 or −16000in each bucket, then the total delta would accumulate to very largepositive or negative amounts. This would be an unacceptable result forthe bank.

If the delta aggregated on level 3, i.e. in the buckets between 0 to 2years, 2 to 5 years, 5 to 10 years and 10+ years had the same sign andthe maximum value, the proposal would have an unacceptable delta profilefor the bank. To avoid such aggregation effects, the bank sets atolerance so that the sum of the delta in the buckets for the timeranges given above is less than the tolerance. In this example, thistolerance is +/−8000 on level 3. As can be seen, the values in the 3year, 4 year and 5 year buckets are (−8532, 16000, −15468) respectively,which sums up to −8000. In this way, the aggregated delta for the 2 to 5year period is then contained by the +/−8000 tolerance and this delta islower than the delta for the individual buckets.

The same applies for the other time ranges on level 3, as well as forthe time ranges on level 2 and level 1.

To have tolerances set on these different levels means that a bank canallow for wider tolerances on the lower (more granular) levels. If ithad not been for the different levels, then a bank with a total deltatolerance of 2000 EUR had been forced to set a time bucket tolerances of2000/24=83 which is far below the now set tolerance of 16000 andclearly, the higher the tolerances for each time bucket the greater thechance of the trade being able to be incorporated into an unwindproposal.

The system 20 could be arranged such that if a party enters thenecessary information into the central computer 28, the system 20 willquantify the savings in terms of capital for market risk, credit risk,operational risk and future operational costs that the party can gain byfollowing the termination proposal.

The market conditions will most likely have changed from the time whenthe net present values and the risk parameters were calculated until thetime when the termination proposals can be executed. Still it is notlikely that the market conditions have changed so dramatically that thetermination proposals are invalid.

The system may be arranged to support the internal enterprise-widerisk-management-tools of party by giving them an external calibrationtool.

The system can also be arranged, for each new deal that one user isabout to make, to propose with which counterparties it would befavourable to execute the deal. This would be done by finding thecounterparties where adding the deal will lower the net exposure on oneor more of the Greeks, thereby making the sum of the transactions lessprone to shifts in the valuation parameters and possibly allow for atermination proposal in the near future, or where the deal would reducecurrent credit exposure. This procedure can also be used in anenvironment where automated quote requests are sent using systems andnetworks, to automatically select the counterparties where the dealwould be most favourable.

Having described particular preferred embodiments of the presentinvention, it is to be appreciated that the embodiments in question areexemplary only and that variations and modifications such as will occurto those possessed of the appropriate knowledge and skills may be madewithout departure from the spirit and scope of the invention as setforth in the appended claims.

1. A system for exchanging OTC (Over the Counter) derivatives relateddata, the system comprising: a plurality of data input/output andprocessing stations, an optional central station and a networkinterconnecting all stations, wherein the data input/output andprocessing stations are operable by parties participating in OTCderivatives related contracts for transmitting and receiving, throughthe network, trade details, including designated maturity dates,mark-to-market values and risk characteristics, for existing OTCderivative transactions carried out with other parties, wherein theoptional central station is for receiving the trade details over thenetwork from the data input/output and processing stations, wherein theexisting OTC derivative transactions include linked OTC derivativetransactions for which the trade details are available for both of theparties to the respective existing OTC derivative transaction; whereinat least one of the data input/output and processing stations oroptional central station includes a processor, wherein the processor isoperable for generating, using the existing linked OTC derivativetransactions, premature termination proposals consisting of packages ofa plurality of linked OTC derivative transactions having designatedmaturity dates, wherein each of the proposals includes at least threeinvolved parties, and wherein the proposals are for prematuretermination of the linked OTC derivative transactions of the packages ata date at which there is no prescribed value and no prescribed method ofdetermining a value at which the termination of the linked OTCderivative transactions of the packages should take place, and at whichthere is no obligation for the involved parties to make prematureterminations of the linked OTC derivative transactions of the packages,wherein there is substantially no financial loss to all of the involvedparties to terminate prematurely before their respective designatedmaturity dates, according to parameters set by the involved parties;wherein the at least one station provides the premature terminationproposal packages to the involved parties for their approval; whereinthe processor is operable, for each new OTC derivative transaction thatone party is about to make, to use the available OTC transaction dataregarding the one party to propose a list of counterparties with whichthere is no substantial financial loss to execute the new OTC derivativetransaction, wherein the list is determined by finding counterparties tothe one party where adding the new OTC derivative transaction will lowernet exposure to one or more of the risk characteristics, thereby makingthe sum of the OTC derivative transactions of the one party lessdependent on changes in valuation parameters and allowing for apremature termination proposal, or where the new OTC derivativetransaction reduces current credit exposure of the one party.
 2. Asystem for exchanging OTC (Over the Counter) derivatives related datacomprising: a plurality of data input/output and processing stations andan optional central station connected to a network interconnecting allstations, wherein the data input/output and processing stations areoperable by parties participating in OTC derivatives related contractsfor transmitting and receiving, through the network, trade details forexisting OTC derivative transactions carried out with other parties,wherein the optional central station is for receiving the trade detailsover the network from the data input/output and processing stations,wherein the existing OTC derivative transactions include linked OTCderivative transactions for which the trade details are available forboth of the parties to the respective existing OTC derivativetransaction; wherein at least one of the data input/output andprocessing stations or optional central station includes a processor,wherein the processor is operable for generating, using the existinglinked OTC derivative transactions, premature termination proposalsconsisting of packages of a plurality of linked OTC derivativetransactions having designated maturity dates, wherein each of theproposals includes at least three involved parties, and wherein theproposals are for premature termination of the linked OTC derivativetransactions of the packages at a date at which there is no prescribedvalue and no prescribed method of determining a value at which thetermination of the linked OTC derivative transactions of the packagesshould take place, and at which there is no obligation for the involvedparties to make premature terminations of the linked OTC derivativetransactions of the packages, wherein there is substantially nofinancial loss to all of the involved parties to terminate prematurelybefore their respective designated maturity dates, according toparameters set by the involved parties; wherein the at least one stationprovides the premature termination proposal packages to the involvedparties for their approval.
 3. The system of claim 2, wherein the tradedetails transmitted via the data input/output and processing stationsinclude designated maturity dates, mark-to-market values and riskcharacteristics.
 4. The system of claim 3, wherein the riskcharacteristics transmitted via the data input/output and processingstations are indicated as Greeks.
 5. The system of claim 4, wherein theprocessor, based on tolerance-limits entered by the involved parties onnet present values, maturity dates and/or one or more of the Greeks toidentify intervals they consider to be risk-neutral, generates thepackages having the linked OTC derivative transactions, that aggregatedtogether can be considered to be risk-neutral, whereafter the involvedparties may agree to prematurely terminate the linked OTC derivativetransactions of the package.
 6. The system of claim 5, whereincounterparties of the involved parties can set target values for the netpresent values of a proposal to reduce credit exposures between saidcounterparties or other counterparties of the involved parties and/or toreduce collateral obligations or to prevent collateral obligations fromoccurring, whereafter the system is able, based on the set target netpresent value, to calculate the best premature termination proposalbased on different criteria, where a minimal aggregated risk can be onecriterion.
 7. The system of claim 5, wherein counterparties of theinvolved parties can set target values for one or more of the Greeks ofa proposal in such a way that existing exposures to one or more of theGreeks between the involved parties can be reduced, whereafter thesystem is able, based on the set target values for the Greeks, tocalculate the best premature termination proposal based on differentcriteria, where a minimal aggregated present value can be one criterion.8. The system of claim 4, arranged to produce a list of all OTCderivative transactions where the individual or aggregatedmark-to-market valuation of trades are such, that there is substantiallyno financial loss to both of the involved parties to terminate the OTCderivative transactions, which happens when both of the parties'valuations are within both of the parties' tolerance ranges.
 9. Thesystem of claim 5, wherein counterparties of the involved parties eachenter into the system data specifying: which OTC derivative transactionsshould not be considered in the composition of proposals; andallowability of partial premature terminations of existing OTCderivative transactions.
 10. The system of claim 5, wherein the systemproduces legally binding trade terminations if all pre-agreed parametersare met.
 11. The system of claim 3, wherein several bilateralsub-proposals are produced from a matching process between three or moreof the involved parties.
 12. The system of claim 11, wherein theparameters of each of the several bilateral sub-proposals including therisk characteristics target values and tolerance limits for each of theinvolved parties are summed and considered for determining acceptablerisk-neutral packages.
 13. The system of claim 12, wherein the systemselects the involved parties in such a way that they have circularclaims, and designs the premature termination proposals in such a waythat the claims are reduced.
 14. The system of claim 3, arranged, foreach new OTC derivative transaction that one user is about to make, topropose a list of counterparties with which there is no substantialfinancial loss to execute the new OTC derivative transaction, which isdone by finding the counterparties where adding the new OTC derivativetransaction will lower net exposure to one or more of the riskcharacteristics, thereby making the sum of the OTC derivativetransactions less dependent on changes in valuation parameters and allowfor a premature termination proposal, or where the new OTC derivativetransaction reduces current credit exposure.
 15. The system of claim 14,wherein automated quote requests are sent to other participants, usingthe network, and to counterparties of the involved parties selected bythe system based upon preferences entered by the users where there is nosubstantial financial loss for the new OTC derivative transaction from acombination of risk and/or credit exposure point of view as well as froma price at which the new OTC derivative transaction is concluded. 16.The system of claim 2, wherein the processor is operable for generatingthe proposals using at least one linked OTC derivative transactioncreated by the processor.
 17. The system of claim 2, wherein severalbilateral sub-proposals are produced from a matching process betweenthree or more of the involved parties.
 18. The system of claim 2,wherein the existing OTC derivative transactions include at least afirst linked OTC derivative transaction, which has previously beenassigned or novated from another party to one of the parties submittingthe trade details with the approval of a counterparty to the first OTCtransaction.
 19. A computer-implemented method for exchanging OTC (Overthe Counter) derivatives related data, wherein the OTC derivativesrelated data describe OTC derivative transactions having designatedmaturity dates, the method comprising: transmitting trade details byparties involved in OTC derivatives related contracts using at least oneof a plurality of data input/output and processing stations, wherein anetwork interconnects the data input/output and processing stations andan optional central station, wherein the transmitting of the tradedetails by the parties is through the network to each other or thecentral station for OTC derivative transactions done with other parties,and wherein each party's transmitted trade details are for existing OTCderivative transactions carried out with other parties, wherein theexisting OTC derivative transactions include linked OTC derivativetransactions for which the trade details are available for both of theparties to the respective existing OTC derivative transaction;generating, by a processor of at least one of the data input/output andprocessing stations or the central station, using the existing linkedOTC derivative transactions, premature termination consisting ofpackages of a plurality of linked OTC derivative transactions involvingat least three parties and having designated maturity dates, wherein theproposals are for premature termination of the linked OTC derivativetransactions of the packages at a date at which there is no prescribedvalue and no prescribed method of determining a value at which thetermination of the linked OTC derivative transactions of the packagesshould take place, and at which there is no obligation for the involvedparties to make premature terminations of the linked OTC derivativetransactions of the packages, wherein there is substantially nofinancial loss to all of the involved parties to terminate prematurelybefore their respective designated maturity dates, according toparameters set by the involved parties; and providing, by the at leastone station, the premature termination proposal packages to the involvedparties for their approval.
 20. The method of claim 19, wherein thegenerating of the proposals includes using at least one linked OTCderivative transaction created by the processor.
 21. The method of claim19, wherein the transmitting step comprises transmitting at least afirst linked OTC derivative transaction, which has previously beenassigned or novated from another party to one of the parties submittingthe trade details with the approval of a counterparty to the first OTCtransaction.